Optimal Monetary Policy When Inflation Dynamics are Uncertain and Non-Orthogonal to Shocks

This paper indicates a contradiction with respect to the optimal neutral policy rate between two seminal contributions on the implications of uncertain economic dynamics for optimal monetary policy. While Craine (1979) implies tighter policy, Söderström (2002) finds certainty equivalence. This conflict is solved by showing how different combinations of normalizing and imposing independence conditions lead to distinct specifications of the covariance between inflation persistence parameter and inflation shock. Moreover, the paper discusses this covariance in the light of the microfoundations of the hybrid New Keynesian Phillips-curve, finding inflation persistence to be non-orthogonal to shocks